What is the MCLR and how does it affect the economy

The marginal cost of funds-based lending rate (MCLR) is an internal reference rate for banks fixed by the Reserve Bank of India (RBI). It helps banks to define the minimum interest rate on different types of loans.

Banks cannot lend below the MCLR, or they will face strict regulatory action. However, they can lend below the MCLR in some exceptional cases with prior authorization from the RBI. The lending interest rate is determined basis the marginal cost or incremental cost of arranging each rupee for the borrower.

When Did MCLR Come into Force?

The RBI replaced the base rate system for determining interest rates with the MCLR system on Apr 01, 2016. While borrowers who were issued loans before Apr 01, 2016, are still under the old base rate and benchmark prime lending rate (BPLR) system, they can opt to move to the MCLR rate if they think it's beneficial.

Why MCLR?

Why did the central bank move banks to the MCLR system when the base rate and BPLR worked fine? The RBI was not satisfied with the effectiveness of the base rate system. That's why it decided to move banks to the new system to benefit borrowers and the country's economy.

The RBI figured out that the base rate system was not sensitive to changes in the policy rates, which is vital for the proper implementation of monetary policies in the country. Before the central bank made it mandatory for banks to follow the MCLR system, there was no uniform system in place. Banks were calculating the base rate based on various methodologies as per their discretion. While some were using the average cost of funds, others used the blended cost of funds and the marginal cost of funds.

Most importantly, the RBI moved banks to the MCLR system to ensure the swifter transmission of its policy rates into banks' lending rates. Therefore, the MCLR came into effect to fulfill the following objectives:

1. Enhance transmission of RBI policy rates into the country's banking system.

2. Improve transparency in the system utilized by banks to fix interest rates on loans.

3. Ensure fairness in credit interest rates for both banks and borrowers.

4. It provides a competitive advantage to banks and boosts their long-term value while contributing to the country's economic growth.

How does the MCLR affect the economy?

The banking system is the lifeblood of the economy, and any negative or positive changes in the sector directly impact the economy. The MCLR system aims to improve the faith of the individual borrowers and business in the banking sector. By improving transparency in how lending rates are calculated, it encourages more individuals and entrepreneurs to rely on the country's banking system for their credit needs.

Moreover, the MCLR, by enhancing the faster and effective transmission of policy rates, helps the country's financial regulatory body to take more effective monetary policy measures. The MCLR system will also ensure that the RBI's interest rate cuts will directly reduce Equated Monthly Instalments (EMIs) on loans.

How to Find a Bank's MCLR Rate?

According to RBI's regulation, banks should publish their minimum loan rate or MCLR for various tenures monthly. These tenures/ maturities include overnight, one month, three months, six months, one year, and any other tenure that the bank may desire to publish. You can find out the MCLR rate of different banks by visiting their official websites.

Is It Mandatory For Me To Link My Loans To MCLR?

The answer is 'Yes,' if you have taken an Auto Loan or Travel Loan. No, if you have taken a Home Loan or Business Loan.

Effective Oct 01, 2019, the RBI introduced the external benchmarking system to replace the MCLR for Home Loans, Business Loans, and working capital loans, etc. This new lending rate system is only applicable for loans with floating interest rates and is not applicable for fixed interest loans. Also, the external benchmarking system will only be implemented in banks. Non-Banking Financial Companies (NBFCs) are out of its purview.2

With this new system in place, banks are now able to offer external benchmark-linked loans that are either connected to the RBI repo rate, Government of India treasury bills, or any other benchmark interest rate issued by the Financial Benchmarks India Pvt. Ltd.3

These initiatives taken by the RBI to improve transparency and effectiveness in the banking system is commendable. Hopefully, these changes will play a big role in boosting retail consumption and improving the country's business morale.

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